What Matters More Than A Company's Dividend Yield?

{ Euclidean Q3 2012 Letter }

A number of friends and investors have asked about how a company’s dividend policy factors into our analysis. These questions have increased over time, reflecting a growing interest in dividend paying stocks as alternative sources of income in a low-yield government bond environment.

This interest in stock dividend income has driven strong price appreciation in large capitalization dividend-payers over the past 18 months – a period in which Euclidean’s returns have underperformed. We feel, therefore, that it is now timely to review how Euclidean’s investment process considers dividends and has us generally investing in companies that have not benefited from this recent rally.

Dividend Yield as Indicator of Future Returns

Across prior decades, whether you focused your investments into dividend-paying companies in general or into high-yielding companies specifically, a number of studies show that you would likely have generated long-term returns above the broad market averages. This seems logical. By focusing on dividend payers, you exclude companies that consume capital and include only those that actually generate some level of cash that can be distributed to shareholders. By focusing on high-yielders, you focus on a subset of the dividend-paying universe that is likely to have low prices in relation to earnings. That you might do well buying cash-generating companies, especially when their shares are inexpensive, should come as no surprise.

In Euclidean’s research, however, we did not find that a company’s dividend yield was the most predictive indicator of prospective returns; rather, we found that a company’s dividend policy and history of dividend payments are imperfect proxies for something even more meaningful to long-term investors.

What We Found To Be Meaningful

Consider this: Companies come in many forms. They build different types of products and provide a wide variety of services. Some serve consumers, others sell to other businesses, and quite a few have governments as their primary customers. Despite these differences, all companies can be thought of as entities that require, deploy, and (hopefully) generate capital that enhances the wealth of shareholders.

In this context, as Euclidean uses machine learning to uncover history’s lessons on evaluating individual companies as potential investments, we have tested many different ways of understanding how well a given company accomplishes the above process. This search has included the evaluation of an entire class of methods for understanding dividends, such as the consistency with which dividends have been paid, the percentage of earnings that have been paid out as dividends, and whether dividends have been growing over time.

While our research suggests that all of these qualities have meaning, they do not prove to be the best areas to explore when evaluating a company’s intrinsic value. Instead, we found the best clues in thoroughly evaluating the character of a company’s long-term returns on capital. Return on capital is simply the earnings a business generates viewed in relation to the total amount of capital invested in the business.

Why Was Return On Capital Found To Be So Important?

Unlike dividend-related metrics, which focus on only one class of management’s options for deploying excess capital, we believe return on capital provides a more encompassing means of understanding the character of a business. In fact, it allows one to quantify certain qualities that might otherwise seem to be only qualitative in nature. For example, if a company has a unique product or strong brand that gives it a ‘competitive moat’, then that business should show persistently and unusually high returns on capital. Otherwise, competitors’ efforts would force the company to reduce prices or invest more in product innovation such that returns on capital decrease. Another example is that, when examined over long periods, return on capital allows you to evaluate the strength of management. By exposing the fingerprints of every capital allocation decision that a company has made since its inception, returns on capital reveal just how strong and shareholder friendly management has actually been.

To appreciate this, consider the options management teams have when their companies generate income. First, they will generally need to reinvest some earnings just to maintain the current level of business. For example, stores, trucks, and factories will need to be remodeled, replaced, or retooled over time at a rate loosely approximating that at which their values are depreciated on a company’s books. Once these non-discretionary investments have been satisfied, however, management teams have very important decisions to make regarding what to do with excess cash. Their options include the following:

Paying dividends

Buying back stock

Reinvesting in the business

Acquiring other companies

Paying down debt

Holding cash

Each of these options that management chooses over time affects long-term returns on capital. The reinvestment options increase capital and, hopefully, also increase earnings at a proportionate rate. The disbursement options (dividends and share repurchases) decrease capital.

From a long-term investor’s perspective, neither class of options (to reinvest or distribute) proves to be inherently better than the other; instead, our findings support what common sense might suggest: the best capital allocation decisions depend on a company’s business life cycle and competitive environment, and they result in a business retaining the maximum of amount of capital with which it can generate high prospective returns.

When Dividend Payers Can Prove To Be Bad Investments

Think back ten years to the start of 2002, and imagine you wanted to build a portfolio of equities that yielded strong dividend income. You may have noticed companies like Newell Rubbermaid, RR Donnelley and Alcoa that were yielding 3.1%, 3.3%, and 1.7% respectively. As large established companies, they might have been thought of as safe investments. After all, it would have been hard to imagine a world without RR Donnelly’s printed books, Alcoa’s aluminum, or – if you have young children as we do – Newell’s Graco car seats.

Over the next 10 years, all three companies would have delivered what you looked for as they paid out substantial dividends along the way. They would also, however, have proven to be bad investments.

That all three ended up being bad long-term investments should not be surprising; they weren’t priced at a discount in January 2002, and they did poor jobs generating enough earnings when viewed in the context of the total amount of capital (equity and debt) invested in their businesses. [1][2]

This wealth destruction resembles what occurs when investors hold long-term bonds with below-average coupons. Just as bond prices eventually fall to push yields up toward market rates, fully priced companies that generate inadequate returns on capital eventually see their market valuations decline. As an example, consider a company with no debt such that its shareholders’ equity, or book value, is the same as its total capital. If this company generates returns on capital that are half the market average, one should expect its shares to eventually sell at half the price-to-book ratio of other debt-free companies because only at that price would prospective investors expect to receive a market return.

When Companies Should Not Pay Dividends

Euclidean found that long-term return on capital was more important than dividend-related metrics when attempting to understand the character of a business and estimate its intrinsic value. Given this, it is interesting to consider situations when it is in long-term shareholders’ interests for companies not to pay dividends.

Imagine a company that has for years generated 20% returns on capital while reinvesting all earnings. If there is good reason to believe that $1 reinvested can continue to generate an incremental $0.20 in annual earnings, then management should only consider alternative options for deploying capital that can deliver similar or greater returns.

To simplify the example, again assume that this company has little debt such that the “capital” in the return on capital equation resembles the equity, or book value, of the business. If its shares are offered at an inexpensive price, such as near book value, then repurchasing shares may have a similar 20% return profile as reinvesting in the business. Repurchasing shares, however, would make little sense if this company’s market capitalization was three times book value. At that valuation, it would require $3 in share repurchases to expand existing shareholders’ claim on earnings by $0.20. The yield on those repurchases would be only 7%, a far lower return in this instance than if management had reinvested earnings.

Regardless of how this company’s shares are priced, paying a dividend would be an unattractive option. With dividends, its owners would receive cash that they would first have to pay taxes on and then, given today’s interest rates, have difficulty redeploying in other investments yielding more than 7% (this company’s current yield on share repurchases) or 20% (its yield on reinvested dollars).

Above are examples of companies that served their shareholders well by prioritizing the reinvestment of earnings over the past decade. The share price appreciation over the 10 years reflects the compounding effects of reinvesting capital at persistently high rates of return. More recently, all three companies have been returning dollars to shareholders in the form of share repurchases, dividend initiations, and dividend growth. [3][4]

How Euclidean’s Investment Process Considers Return On Capital

Certainly, many companies should pay dividends and there are many dividend paying companies that have proven to be exceptional investments. It is not possible, however, to sustainably pay dividends without substantial and consistent earnings. Return on capital, therefore, provides a basis for evaluating the character of dividend-paying businesses, just as it does for those companies that reinvest. If you want to evaluate whether a company’s management team will have the option to initiate, continue paying, or increase a dividend, you now know where Euclidean’s research would suggest you look.

With this said, long-term averages of return on capital have their limitations. Companies with high returns often see them erode as new competitors emerge or as they run out of opportunities to productively deploy capital. Moreover, as 2002 investors in companies such as Dell or Harley Davidson would have learned, you can pay too much for a company with good returns on capital and end up with a bad long-term investment.

So, while our machine-learning process found long-term returns on capital to be a fruitful area of exploration, it also found that those returns needed to be viewed in relation to other important qualities of a business, including consistency of operations, rate of growth, risk on the balance sheet, and valuation in relation to earnings.

Today, as we apply our investment process, we find the right combination of these qualities in out-of-favor, generally small to mid-cap technology, healthcare, education, and retail companies. Collectively, our portfolio now shows long-term, pre-tax returns on capital in excess of 25% and a four-year average earnings yield [5] above 30%. We believe that these characteristics, coupled as they are with revenue growth and large net cash balances on conservative balance sheets, have historically been associated with high-returning, high-probability equity investments. The reason that our portfolio is light on large, well-known, dividend-paying companies is alluded to on the next page. Those companies do not measure up on the traits we found to be most closely associated with long-term investing success.

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Please let us know if you have any thoughts or comments on this letter. We look forward to connecting with you in the weeks ahead.

[1] Return on capital is calculated by taking a company’s net income divided by its total capital (equity + LT Debt) at the end of each year. The 10-year average reflects the average of the prior 10-years’ ending returns on capital.

[2] Total Return reflects the impact of share price appreciation / depreciation and dividend payments across the period from January 2002 through December 2011.

[3] Return on capital is calculated by taking a company’s net income divided by its total capital (equity + LT Debt) at the end of each year. The 10-year average reflects the average of the prior 10-years’ ending returns on capital.

[4] Total Return reflects the impact of share price appreciation / depreciation and dividend payments across the period from January 2002 through December 2011.

We share these numbers because they are easy-to-communicate measures that show the results of our systematic process for buying shares in historically sound companies when their earnings are on sale. [6] [7]

It is important to note that Euclidean uses similar concepts but different measures to assess individual companies as potential investments. Our models look at certain metrics over longer periods and seek to understand their volatility and rate of growth. Our process also makes a series of adjustments to company financial statements that our research has found to more accurately assess results, makes complex trade-offs between measures, and so on. These numbers should, however, give you a sense of what you own as a Euclidean Investor. In general, higher numbers for these measures are more attractive. The key measures are:

Earnings Yield – This measures how inexpensive a company is in relation to its demonstrated ability to generate cash for its owners. A company with twice the earnings yield as another is half as expensive; therefore, all else being equal, we seek companies with very high Earnings Yields. Earnings Yield reflects a company’s past four-year average earnings before interest and tax, divided by its current enterprise value (enterprise value = market value + debt – cash).

Return on Capital – This measures how well a company has historically generated cash for its owners in relation to how much capital has been invested (equity and long-term debt) in the business. At its highest level, this measure reflects two important things. First, it is an indicator of whether a company’s business is efficient at deploying capital in a way that generates additional income for its shareholders. Second, it indicates whether management has good discipline in deciding what to do with the cash it generates. For example, all else being equal, companies that overpay for acquisitions, or retain more capital than they can productively deploy, will show lower returns on capital than businesses that do the opposite. Return on Capital reflects a company’s four-year average earnings before interest and tax, divided by its current equity + long-term debt.

Equity / Assets – This measures how much of a company’s assets can be claimed by its common shareholders versus being claimed by others. High numbers here imply that the company owns a large portion of its figurative “house” and, all else being equal, indicates a better readiness to weather tough times.

Revenue Growth Rate – This is the annualized rate a company has grown over the past four years.

[6] All Euclidean measures are formed by summing the values of Euclidean’s pro-rata share of each portfolio company’s financials. That is, if Euclidean owns 1% of a company’s shares, it first calculates 1% of that company’s market value, revenue, debt, assets, earnings, and so on. Then, it sums those numbers with its pro-rata share of all other portfolio companies. This provides the total revenue, assets, earnings, etc. across the portfolio that are used to calculate the portfolio’s aggregate measures presented here.

[7] The S&P 500 measures are calculated in a similar way as described above. The market values, revenue, debt, assets, earnings, etc., for each company in the S&P 500 are added together. Those aggregate numbers are then used to calculate the metrics above. For example, the earnings yield of the S&P 500 is calculated as the total average four-year earnings before interest and taxes across all 500 companies divided by those companies’ collective enterprise values (all 500 companies’ market values + cash – debt).

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